Security

bond market

02/24/2011

Financial markets all-but yawned on Tuesday when Moody’s issued a negative outlook on its ratings of Japanese national bonds. Markets were similarly unfazed late last month when S&P took the more significant step of downgrading its rating of Japanese government debt.

Questions inevitably arise: What do the markets know that Moody’s and S&P don’t? Or, why do Moody’s and S&P continue to tell financiers what they seem to already know about Japan, and apparently have already discounted when making investment decisions? Perhaps most importantly, why do pronouncements from the ratings agencies about Japan receive far more media coverage than seems warranted, judging by the shrugs with which the news is met by market players?

To be fair, Moody’s and S&P have a job to do. By all accounts, Japan is carrying a growing national debt burden that, left unaddressed, will at some point begin to cause serious economic dislocations. Investors need to know this; Moody’s and S&P tell them.

But that’s not the whole story. Moody’s and S&P have a long history of inaccurately assessing the immediacy of Japan’s fiscal troubles. They have fueled false economic comparisons between Japan and some Asian and Europeans countries – most recently Greece – that have gone through genuine economic crises in recent years in part due to excessive government debt. And they have based their ratings on questionable – certainly debatable – assessments of the ability of Japan’s political world to tackle pressing economic challenges. Overall, however inadvertently, Moody’s and S&P have fed a false, negative narrative of a Japan hopelessly on a path to national ruin.

Here are some things to keep in mind when evaluating commentaries on Japan issued by Moody’s and S&P.

HISTORY OF EXAGGERATIONS: Exactly 11 years ago – February 2000 – Moody’s issued a warning about Japan’s national debt that reads today as if it were the template for Tuesday’s announcement. Bloomberg News, February 17, 2000 wrote: “Japan’s credit rating may be cut, Moody’s Investors Service said, noting that government debt is swelling and that there’s little chance it can be reduced without threatening economic growth.” Five months later – July 10, 2000 -- Business Week carried acommentary arguing that national debt was a “tsunami threatening Japan.” The magazine wrote: “Already, new alarm bells are sounding: Moody’s Investors Service is considering downgrading Japan’s debt unless Tokyo comes up with a convincing plan to reduce its mounting liabilities.” Sound familiar? It should. Four weeks ago, in its January 27 downgrading of Japan’s sovereign debt, S&P justified its move by arguing that the government in Tokyo lacks “a coherent strategy” to improve its fiscal situation. And who was there to endorse the S&P move? Business Week, which carried a January 30 commentary that read in part: “[C]oncerns about a Japanese debt crash are based on solid foundations.”

Keep in mind that after a full decade of warnings of imminent financial crisis in Japan, both Moody’s and S&P still rate Japan’s national debt instruments as “high grade,” or only “slightly riskier than those with the top rating,” according to Dow Jones.

FALSE COMPARISONS: Dire warnings of imminent financial crisis in Japan have endured in part because they are based on faulty economic logic, including that Japan is somehow similar to European countries, especially Greece, Spain, and Ireland. The latter countries have both internal imbalances in the form of budget deficits and high government debt, and large external (current account) deficits. That double-deficit condition also existed in Thailand, South Korea, and other Asian nations that experienced horrific financial crises in 1997-1998.

Japan, by contrast, has a large current account surplus, putting the country at virtually no risk any time soon of the kind of crisis that gripped Greece last year, and wreaked havoc in Asia more than a decade ago. Chronic current account deficits put downward pressure on a nation’s currency, making it more likely foreign investors will flee. Capital flight makes it more difficult to finance government budget deficits, leading to big budget cuts and depressed economic activity. That, in turn, leads to more capital flight, and a downward economic spiral.

Unlike Greece, Spain, and Ireland, Japan is in no such danger.

Also faulty is the argument that Japan is facing a huge debt crisis. Fortune’s Katie Benner put it this way on January 27: “Japan is en route to a national debt crisis and a massive devaluation of the yen.”

The debt crisis argument goes like this: Up to now, many have seen Japan’s financial situation as stable because 90% of the combined local and national government debt is owed to Japanese investors. In that sense, the government debt is an ‘obligation to pay’ on one side of the accounting ledger, but is a ‘source of income’ for Japanese citizens on the other side of the ledger. There is no net drain on the resources of Japan as a whole.

The root of this second concern, reflected in the Moody’s and S&P actions, is that the aging of Japan’s population will lead to a steady decline in the nation’s savings rate, and thus a decline in the pool of available capital to finance the debt of the local and national governments. Without the pool of domestic capital, Japan would have to increasingly rely on foreign capital to finance government debt, which would eventually lead to a debt crisis and yen devaluation.

But Moody’s itself acknowledged in its statement that “Japan’s very large economy and very deep financial markets provide the wherewithal” to put off any crisis in the near-to-medium term. Dow Jones agreed, saying that “any debt crisis is considered years away.”

DEBATABLE POLITICAL ASSESSMENTS: Instead, for both Moody’s and S&P, the issues facing Japan right now are more political than economic: is the country moving to tackle gnawing structural problems before they cause truly critical financial dislocations? Both agencies are skeptical. But there is plenty of room to debate their respective assessments. Prime Minister Naoto Kan has staked his political career on calls to raise the nation’s consumption tax, as part of a broader plan to address Japan’s fiscal woes, and he is battling Japan’s entrenched farm lobby so as to enter regional free trade talks. Kan has also brought into his Cabinet one of Japan’s toughest fiscal hawks, the veteran Kaoru Yosano, to help oversee fiscal restructuring efforts.

S&P dismisses these efforts. The Economist quotes Takahira Ogawa, the S&P analyst who downgraded Japan’s debt: “They can say whatever they like. I seriously doubt how much groundwork they have done.”

But bond-market strategist Nhan Ngoc Le of Morgan Stanley takes issue, telling Dow Jones: “Yes the fiscal problem is getting worse, and you can’t simply ignore that. But the Japanese government still has a lot of room to address it, and I think that the political will is changing.”

As if on cue, Taro Kono, a rising star in the opposition Liberal Democratic Party, seemed to demonstrate that point, telling Dow Jones that his party’s attempts to block passage of the Kan government’s fiscal measures are misguided. “The two parties need to sit down and learn how to reach an agreement.”

FALSE NARRATIVE: The point here is not that Moody’s and S&P are completely wrong, but that their respective assessments provide just snapshots of a Japan that is much more dynamic and multidimensional than any snapshot can portray. Their assessments both reflect and fuel a relentlessly pessimistic tendency in Japan these days to amplify and overstress every shortcoming in the country’s political system, while seeming to cynically dismiss anything even remotely hopeful.

A particularly telling example emerged in Tokyo on January 27 in coverage of Prime Minister Kan’s reaction to the S&P downgrade of that day. A small army of reporters caught up with Kan, who naively but candidly commented that he had not yet heard the news. Unfortunately for Kan, he used the term “unfamiliar” to express that he had yet to be briefed. Within hours, Japan was filled with irresponsible accounts that Kan had said he was “ignorant” of the matter. As the Wall Street Journal later reported: “Opposition leaders, many analysts and local media outlets jumped on the comments, portraying [Kan] as unfamiliar with basic economic concepts.”

And so it goes, with serious people and discussion trivialized into clownish caricatures of reality.

Less obvious, but perhaps more debilitating, is the way that carelessly downbeat summary estimations evolve unchecked into inaccurate conventional wisdom. This opening line from a February 21 New York Times article is typical: “Japan’s government finances are on the verge of collapse, and its economy has foundered for two decades.”

Moody’s and S&P are only a part of the unbalanced and misleading coverage of Japan these days. But their recent assessments, and the coverage of those assessments, capture the extent of the problem.